Per our bylaws, the board of directors may build up and maintain reasonable reserves for working capital, operations, contingencies and replacements.
“…the board of directors may build up and maintain a reasonable reserve fund for working capital, operations, contingencies and replacements. Extraordinary expenditures not originally included in the annual budget which may become necessary during the year shall be charged first against reserves. If the reserves are insufficient for any reason, including non-payment of any Unit Owner’s assessment, the board of directors may at any time levy a further assessment, which shall be assessed against the unit owners according to their respective undivided interests in the common elements, and which may be payable in a lump sum or in installments as the board of directors may determine.”
The language of our bylaws requires that the board segment (logically at least for accounting purposes) the reserve fund into 3 separate funds: an operating reserve fund, a contingency reserve fund and capital repair/replacement fund.
The size of the operating reserve fund is a judgment that may be informed by dues payment delinquency rates, and various price fluctuations. At Laurel Mews we have historically targeted 5% of our operating budget as an operating reserve. Today, due to a large owner delinquency, the operational reserve is set to closer to 10%.
The size of the contingency reserve fund is a function of likelihood of risks and assessments of their impact. Insurance deductibles can be funded from the contingency reserve fund as well as other rare and unforeseen expenses.
Recent contingencies have included water service pipes ruptures and sewer pipe blockages. Each of those costed well over $15K. Due to the materials used by the developers and the age of our community, we should always be prepared for water service breaks.
Snow/ice removal can also lead to large contingencies. The snow storm of of 2022 was big, but not as big as Snowpocalypse and Snowmaggeddon of 2010, the snowy winters of 2014 and 2016, which meant snow removal contingencies of nearly $7K, $11K, and $14k, respectively. The earthquake of 2011 ended up costing the community over $10K.
But for the most part when people speak of the the ‘reserve fund’ they mainly mean the capital repair/replacement fund. Larger repair/replacement projects have been typically paid for via the capital repair/replacement fund, e.g., replacement of brick walls, brick walkways repairs/replacements, major fence replacements, and lighting system replacements. Smaller projects, on the other hand, are typically funded via the operating budget as part of the annual maintenance plan. You can imagine how your property value would decline if we let these items fall into disrepair. You can also imagine that a potential buyer would be more willing to buy into a stably financed condominium community that plans for capital item repairs and replacements rather than not. This of course has to be balanced against the attractiveness of low HOA fees, which might not be as attractive as one might think.
The capital repair/replacement fund budget is different from the operating budget in that the former consists of a multi-year plan, as much as 30 years. In the medium term, say 5 years, the board may program a capital repair/replacement project with more focused cost estimates and funding plans. Then at some point, a programmed capital repair/replacement project will be budgeted in detail and included in some year’s annual maintenance plan based on an exact estimate or even a performance contract. And finally the project is executed under some current-year budget plan.
How much to have in the capital repair/replacement fund is the question answered in a “reserve study”. Studies done by Reserve Specialists are normally restricted to components of the property that are to be replaced by the HOA according to the rules and bylaws. These are usually just common elements (such as streets, parking lot, lighting, walkways, brick walls), but it can include portions of limited common elements or units if the rules and bylaws so specify.
This document provides a good framework for understanding what goes into a reserve report and why. While the mathematics and engineering estimations in reserve studies can be quite complex, conceptually a reserve study is quite simple. It simply lists capital items, cost to repair/replace the items, when the items have to be repaired/replaced, and how much money should a community be saving now to have funding available to repair/replace the item when the time comes to do so. The future costs, item lifetimes, interest rates, and tolerance for “insufficiency” are the key assumptions in the study.
The Virginia Condominium Act at § 55.1-2147 requires that HOAs conduct a reserve study at least every five (5) years to “…determine the necessity and amount of reserves required to repair, replace and restore the capital components; review the results of that study at least annually to determine if reserves are sufficient; make any adjustments the board of directors deems necessary to maintain reserves, as appropriate; and provide a copy or summary of the reserve study report to prospective purchasers.”
Laurel Mews last had a full reserve study done in 2019, with an update done in 2020. Based on the 2019 study and 2020 update, the board of directors in 2020 agreed upon a 20-year plan of capital repairs and replacements, and a 5-year budget plan. Those plans are constantly being reviewed and updated.
The “sufficiency” of the fund is not prescribed by the law, rather that is retained as an individual HOA business decision. Reserve funds can be considered insufficiently funded, sufficiently funded or over-funded subject to the assumptions and purposes that the community agrees upon. If purposes and assumptions change, the funding strategy can change and vice versa. So one can easily become the other if, for instance, the assumptions incumbent with the slow and orderly build-up plan do not actually come to fruition. In that case a capital project could have to be deferred, or a special assessment will be necessary to make up any cash deficit, or conceivably rebates can be made to owners if there is a cash surplus.
Essentially there are three ways to go on funding reserve, repair and replacement items, (1) the owners agree upon a slow and orderly build-up of an owner equity fund over a number of years, (2) the owners do a short-term special assessment in the range of months or years around the time the item needs to be address, or (3) the association resorts to getting a loan.
There are multiple problems associated with option (2), the special assessment route. Not building a reserve fund undercharges the true cost of home ownership. Actually, it is a bit of a mistake to think of the reserve fund contributions as a fund for future replacements. Rather they are paying the cost of present use. In effect, with a special assessment current owners are footing the bill for costs that were rightfully the responsibility of prior owners. Furthermore, with a special assessment, the community is paying all-at-once what it could have paid over time, and actually could have had subsidized via interest payments. Special assessments puts individual owners at risk for civil judgements, liens, and foreclosure if they cannot afford the charge on the schedule that the HOA requires.
Imagine having to experience a double-digit (25%) increase in dues AND a $4,000 special assessment. Kicking the can down the road by under-funding reserves almost always leads to greater in-affordability and economic losses to the association and its members in the end.
Getting a loan, option (3), of course involves paying interest, and also putting the entire association at risk of liens and general foreclosure.
Therefore, it is not surprising that communities with well-funded reserve funds have resale values in excess of 12% over those that do not. In the case of a Laurel Mews Unit that could translate to $84k per transaction, or nearly $2k per owner in equity.
To summarize, Laurel Mews has an operating fund and a 3-purpose reserve fund. The operating fund budget is driven mostly by water/sewage costs. The operational reserve fund is necessary to cover cash flow deficits. The contingency reserve fund helps to cover abnormal expenses that might occur in any given year. The capital repair/replacement reserve fund budget is driven by long-term major capital repair/replacement requirements and assumptions.
The operating budget includes small repair/replacement items, and the operating maintenance budget can augment the capital repair/replacement budget, or vice versa. Then there is contingency maintenance, i.e., sometimes components just do not make to end of their otherwise estimated useful lives. The capital reserve fund requires constant monitoring for changes in conditions that can lead to changes in the assumptions and funding strategy. The capital fund can become under-funded, adequately funded or over-funded if assumptions or objectives should change.
Under-funding the reserve fund, and the association in general, puts owners at greater risks for diminished equity, special assessments, civil judgements and foreclosures.
The reserve fund is owner equity and is included in our home values.
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